Five members of ULI’s Office Development Council speak about the trends affecting their market, including opportunities for development and investment, the evolution of tenant needs, the challenges of adaptive use, and the value of certification under the Leadership in Energy and Environmental Design (LEED) rating system.
Contributing their insights are Jeremy Fletcher, senior managing director of Beacon Capital Partners LLC in Los Angeles; Joe Gorin, managing director and head of office of Rockwood Capital in New York City; Grant Herlitz, president of the Howard Hughes Corporation in Dallas; Jarrett Minton, principal of M-M Properties in Houston and chair of the Office Development Council; and Sam Mitts, executive managing director of portfolio management for USAA Real Estate Company in San Antonio.
Given the slowness of the economic recovery, what are the current opportunities for owners and developers of and investors in office properties?
Jarrett Minton: In the present office market cycle, we are not actively developing office properties. We’re focusing on acquiring office properties, predominantly value-add opportunities. We have been lucky here in Texas. We haven’t seen the same level of stagnation in the office market as in many other parts of the nation. There are several office developments on the boards being proposed in Houston and Dallas, and I wouldn’t be surprised to see something kick off in one or both cities in the next year or so. But I think owners and investors are more focused on value-add and repositioning opportunities. It’s easier from a capital markets perspective to attract investment capital and debt capital for those. You may hear of some smaller speculative projects, but only with very well-capitalized ownership groups. With preleasing, with tenants that perhaps need new-generation space or a new LEED-certified development or a premier location, you can kick off a new project.
Jeremy Fletcher: We focus on the knowledge-based economies in the primary markets, so we invest in office products in Boston, New York, Los Angeles, Washington, D.C., San Francisco, Seattle and the Pacific Northwest, London, and Paris. There are current opportunities in those markets and we are pursuing them. We tend to do more investing on the value-added side, assets that require capital and stabilization—i.e., leasing and then an exit. So we are seeing opportunities, and we’re very active on the acquisition side.
Grant Herlitz: For owners, the opportunities are to reach out to the existing tenant base and make sure that tenants are satisfied. By doing that, owners can ensure that any expansions that they have can be taken advantage of long before those tenants need to come to market, and they have the opportunity to backfill vacant space. For developers of new office buildings, in certain places such as Houston the market isn’t burdened by an oversupply of development from the previous business cycle, so there is more opportunity. It’s going to be harder to finance speculative office buildings, but in certain markets it’s possible. For example, we own the Woodlands, which is supply constrained and has a vacancy rate of about 2.9 percent, so we have the opportunity to build spec office there if we need to, especially with companies like Exxon relocating to just south of the Woodlands.
Sam Mitts: Tenant leases are consistently rolling, providing opportunity for aggressive and creative landlords to attract tenants. Certain 24/7 cities are seeing strong rent growth and demand. With that said, on the investment side you have several opportunities. If you’re looking for core properties, although pricing is aggressive, there is no lack of product to buy. With historically low interest rates, there are opportunities to lock in decent spreads between interest cost and yields. In addition, with half of the $348 billion of commercial loans that mature this year underwater, we expect good investment opportunities as the pressure on those owners/lenders increases. As such, loan-to-own may finally be a viable alternative. Also, note that 70 percent of those underwater loans have loan-to-value ratios that are 100 to 110 percent, so they offer the best opportunity for restructuring. On the development side, we will continue to focus on build-to-suit opportunities, including government, university, and medical projects. Although we might see some spec development kick off in 2012, we expect it to be limited. Overall, however, it is hard not to think that now is a great time in the cycle to expand. We are very much focused on growth right now.
Joe Gorin: A number of markets are treading water, but we are starting to see pockets of growth, most notably in those areas driven by industries such as technology, energy, and, in some instances, health care firms. When you look at areas like Silicon Valley, the biotech corridor within Cambridge, areas of Boston, even in some parts of Texas with the energy companies, we are starting to see some decent positive absorption. As for the opportunities to invest in office product, it’s hard: there is a lot of capital chasing few deals, especially in the core markets. So the opportunities are more in the areas of value-add and recapitalization, investing in distressed debt and/or providing equity to operators who may not have enough equity to invest in assets that need repositioning capital to either retain tenants or attract new tenants. So we focus on opportunities like that, as well as the repositioning of assets that are fundamentally sound.
Where is the tenant demand?
Mitts: Energy, technology, health care, and education. Also, right-to-work states and those with no or limited state income taxes continue to get a lot of our
attention. What does it take to meet these tenants’ needs? Quality, well-kept buildings with strong sponsorship; ability to offer upfront concessions to help them make it through the next six to 18 months; floor plates that allow the tenant layout flexibilities.
Minton: With the slowness of the recovery over the last couple of years, tenants have been reluctant to make long-term decisions. That’s starting to thaw somewhat, especially in Houston: we’ve seen a real demand from energy companies, so we are beginning to see some movement between submarkets. There are some relocations into the market or into the state, but limited expansions. Many companies have downsized, so they have shadow space, and as they start to come out of this recession, they will grow back into their existing space, but they’re not really looking to expand. So I think it’s going to be a slow evolution of seeing significant increases in demand.
Gorin: It’s hard to quantify how much shadow space there is—space that tenants are not using. When we look at buying office buildings, we go space by space and see how many offices are being occupied. With a lot of leases that come up for expiration, in a number of these markets you see renewals, but tenants are downsizing. The question is, how much new leasing activity do you need in a market to trigger positive net absorption?
How are tenants’ needs evolving?
Fletcher: In the two urban markets in the West Coast, for instance, Seattle and San Francisco, tenants are definitely trying to migrate into “cool” space, meaning spaces with exposed concrete and brick, spaces not in a conventional high rise. We are trying to respond to that by refitting some of our existing office space with exposed ductwork and beams and indirect lighting. We have also done a lot of work with gaming companies over the last year, and their spaces are specially built to foster interaction among their highly collaborative designers.
Gorin: A lot of firms are modernizing, and a lot of the office growth is occurring in atypical office sectors, such as technology, social media, and gaming firms. Whereas an old-school law firm might need on average 200 to 250 square feet [19 to 23 sq m] per person, with the modern office we are seeing closer to 150 square feet [14 sq m] per employee because they are going into more of an open-space plan, eliminating the perimeter office layout. And a lot of tenants are focused on efficiencies.
Herlitz: Tenants are much more economically driven than they were a couple of years ago. Efficiency of space is critical to them. A lot of their workers are in and out of the office, so they need much more temporary space. The most efficient building has rectangular floor plates. The fewer corners you have, the fewer rounded edges, the fewer interior columns, the more efficient the floor plates will be. Other efficiencies tenants look for: lighting strategies that drop utility costs, fixed-rate utilities in regulated markets, locking in long-term contracts when natural gas prices are low. It’s incumbent on developers or property managers to make sure that they are operating a building as efficiently as they possibly can so that the gross rental rate that the tenant is paying—both base rate and operating expenses—is as low as possible in a given market.
When does adaptive use make sense?
Herlitz: Adaptive use makes sense in supply-constrained markets—markets like West Los Angeles, where there isn’t much room for development and you’re not going to see much new product. We’ve done it a number of times in Houston where we converted [nonoffice] buildings to office buildings. It’s market driven and tenant driven, so if there is a need, there’s always an opportunity to change the use of the building.
Fletcher: Adaptive use makes sense whenever ground-up development costs significantly exceed the costs required to redevelop an existing structure. The trouble is that existing structures are getting significantly more costly to redevelop, so you have to approach adaptive use depending on whether you think you can create high-quality space in a location that will be successful. South of Market in San Francisco is a good example: it’s a question of whether you can optimally develop space that will work for the type of tenants and the market, and the growth South of Market is primarily in the technology industry, so you have to be very thoughtful about what projects to pursue based on where the real tenant demand is.
Minton: The fundamental challenge is that you have got to get the bay depths right. That’s always the challenge of adapting a building from one use to another. You really do need efficient floor plates and good bay depths in order to have competitive office space. I think it’s easier to bring an older property up to a newer standard without dramatically changing use, but there are limitations on that depending on the age of the asset. I think it makes the most sense if you’re talking about an irreplaceable location, or an asset that has really a strong identity within the community, or a location where the timeline and cost for assembling a site or obtaining approvals is prohibitive.
Is green design still a differentiator? How important is LEED certification?
Gorin: If you’re marketing a redevelopment or a new development, you have to go green or else people will raise their eyebrows. In a lot of the core CBD [central business district] locations, I don’t see LEED as a big differentiator at this point. It’s less costly to achieve LEED certification in some of the Class A suburban buildings. I suspect that the more modern suburban inventory, combined with smaller-sized assets and higher-efficiency mechanical systems, make LEED certification more cost-effective, more relevant, and a greater differentiator in core suburban locations.
Mitts: Green is becoming more of a differentiator, but it very much depends on the tenant. Large corporations are demanding high Energy Star ratings and/or LEED Silver and higher designations. Smaller tenants typically do not seem that concerned about LEED. We are seeing LEED/Energy Star requirements as a part of more RFPs [requests for proposal], with more stringent requirements coming from the U.S. General Services Administration.
Fletcher: We are finding that federal tenants mandate a Gold LEED building or better. Large investment-grade tenants certainly prefer LEED buildings, but with most of them it is not mandatory and the premiums that they will pay are marginal, if any. The cost of building to LEED standards is not great, particularly if it is planned in the beginning of development. And the LEED for Existing Buildings program provides a good template for existing buildings, allowing them to perform at the highest level.